available online.
LOS 39.i: Calculate the value of a property using the cost and sales comparison approaches.
CFA® Program Curriculum, Volume 6, page 46
Cost Approach
The premise behind the cost approach is that a buyer is unlikely to pay more for a property than it would cost to purchase land and build a comparable building. The cost approach involves estimating the market value of the land, estimating the replacement cost of the building, and adjusting for depreciation and obsolescence. The cost approach is often used for unusual properties or properties where comparable transactions are limited.
PROFESSOR’S NOTE
Depreciation for appraisal purposes is not the same as depreciation used for financial reporting or tax reporting purposes. Financial depreciation and tax depreciation involve the allocation of original cost over time. For appraisal purposes, depreciation represents an actual decline in value.
The steps involved in applying the cost approach are as follows:
Step 1: Estimate the market value of the land. The value of the land is estimated separately, often using the sales comparison approach.
Step 2: Estimate the building’s replacement cost. Replacement cost is based on current construction costs and standards and should include any builder/developer’s profit.
PROFESSOR’S NOTE
Replacement cost refers to the cost of a building having the same utility but constructed with modern building materials. Reproduction cost refers to the cost of reproducing an exact replica of the building using the same building materials, architectural design, and quality of construction.
Replacement cost is usually more relevant for appraisal purposes because reproduction cost may be uneconomical.
Step 3: Deduct depreciation including physical deterioration, functional obsolescence, locational obsolescence, and economic obsolescence. Physical deterioration is related to the building’s age and occurs as a result of normal wear and tear over time.
Physical deterioration can be curable or incurable. An item is curable if the benefit of fixing the problem is at least as much as the cost to cure. For example, replacing the roof will likely increase the value of the building by at least as much as the cost of the roof. The cost of fixing curable items is subtracted from replacement cost.
An item is incurable if the problem is not economically feasible to remedy. For example, the cost of fixing a structural problem might exceed the benefit of the repair. Since an incurable defect would not be fixed, depreciation can be estimated based on the effective age of the property relative to its total economic life. For example, the physical depreciation of a property with an effective age of 30 years and a 50-year total economic life is 60% (30 year effective age / 50 year economic life). To avoid double counting, the age/life ratio is
multiplied by and deducted from replacement cost minus the cost of fixing curable items.
PROFESSOR’S NOTE
The effective age and the actual age can differ as a result of above-normal or below-normal wear and tear. Incurable items increase the effective age of the property.
Functional obsolescence is the loss in value resulting from defects in design that impairs a building’s utility. For example, a building might have a bad floor plan. As a result of functional obsolescence, NOI is usually lower than it otherwise would be because of lower rent or higher operating expenses. Functional obsolescence can be estimated by capitalizing the decline in NOI.
Locational obsolescence occurs when the location is no longer optimal. For example, five years after a luxury apartment complex is completed, a prison is built down the street making the location of the apartment complex less desirable. As a result, lower rental rates will decrease the value of the complex. Care must be taken in deducting the loss in value because part of the loss is likely already reflected in the market value of the land.
Economic obsolescence occurs when new construction is not feasible under current economic conditions. This can occur when rental rates are not sufficient to support the property.
Consequently, the replacement cost of the subject property exceeds the value of a new building if it was developed.
EXAMPLE: The cost approach
Heavenly Towers is a 200,000 square foot high-rise apartment building located in the downtown area.
The building has an effective age of 10 years, while its total economic life is estimated at 40 years. The building has a structural problem that is not feasible to repair. The building also needs a new roof at a cost of €1,000,000. The new roof will increase the value of the building by €1,300,000.
The bedrooms in each apartment are too small and the floor plans are awkward. As a result of the poor design, rents are €400,000 a year lower than competing properties.
When Heavenly Towers was originally built, it was located across the street from a park. Five years ago, the city converted the park to a sewage treatment plant. The negative impact on rents is estimated at
€600,000 a year.
Due to recent construction of competing properties, vacancy rates have increased significantly resulting in an estimated loss in value of €1,200,000.
The cost to replace Heavenly Towers is estimated at €400 per square foot plus builder profit of €5,000,000.
The market value of the land is estimated at €20,000,000. An appropriate cap rate is 8%. Using the cost approach, estimate the value of Heavenly Towers.
Answer:
Replacement cost including builder profit [(200,000 SF × €400 per SF) + 5,000,000] 85,000,000
Curable physical deterioration − new roof (1,000,000)
Replacement cost after curable physical deterioration €84,000,000 Incurable physical deterioration – structural problem [(10-year effective age / 40
year life) × 84,000,000] (21,000,000)
Incurable functional obsolescence − poor design [400,000 lower rent / 8% cap rate] (5,000,000) Locational obsolescence − sewage plant [600,000 lower rent / 8% cap rate] (7,500,000)
Economic obsolescence − competing properties (1,200,000)
Market value of land 20,000,000
Estimated value using the cost approach €69,300,000
PROFESSOR’S NOTE
We don’t use the €1,300,000 for anything, except to determine that physical deterioration of the new roof is curable.
Because of the difficulty in measuring depreciation and obsolescence, the cost approach is most useful when the subject property is relatively new.
The cost approach is sometimes considered the upper limit of value since an investor would never pay more than the cost to build a comparable building. However, investors must consider that construction is time consuming and there may not be enough demand for another building of the same type. That said, market values that exceed the implied value of the cost approach are questionable.
Sales Comparison Approach
The premise of the sales comparison approach is that a buyer would pay no more for a property than others are paying for similar properties in the current market. Ideally, the comparable properties would be identical to the subject but, of course, this is impossible since all properties are different. Consequently, the sales prices of similar (comparable) properties are adjusted for differences with the subject property. The differences may relate to size, age, location, property condition, and market conditions at the time of sale. The values of
comparable transactions are adjusted upward (downward) for undesirable (desirable)
differences with the subject property. We do this to value the comparable as if it was similar to the subject property.
EXAMPLE: Sales comparison approach
An appraiser has been asked to estimate the value of a warehouse and has collected the following information:
Unit of Comparison Subject Property Comparable Transactions
1 2 3
Size, in square feet 30,000 40,000 20,000 35,000
Age, in years 5 9 4 5
Physical condition Average Good Average Poor
Location Prime Prime Secondary Prime
Sale date, months ago 6 18 12
Sales price $9,000,000 $4,500,000 $8,000,000
The appraiser’s adjustments are based on the following:
Each adjustment is based on the unadjusted sales price of the comparable.
Properties depreciate at 2% per annum. Since comparable #1 is four years older than the subject, an upward adjustment of $720,000 is made [$9,000,000 × 2% × 4 years].
Condition adjustment: Good: +5%, average: none; poor: –5%. Because comparable #1 is in better condition than the subject, a downward adjustment of $450,000 is made [$9,000,000 × 5%].
Similarly, an upward adjustment is made for comparable #3 to the tune of $400,000 [$8,000,000 × 5%].
Location adjustment: Prime − none, secondary − 10%. Because both comparable #1 and the subject are in a prime location, no adjustment is made.
Over the past 24 months, sales prices have been appreciating 0.5% per month. Because comparable
#1 was sold six months ago, an upward adjustment of $270,000 is made [$9,000,000 × 0.5% × 6 months].
Answer:
Once the adjustments are made for all of the comparable transactions, the adjusted sales price per square foot of the comparable transactions are averaged and applied to the subject property as follows:
Comparable Transactions
Adjustments Subject Property
1 2 3
Sales price $9,000,000 $4,500,000 $8,000,000
Age +720,000 –90,000 –
Condition –450,000 – +400,000
Location – +450,000 –
Sale date +270,000 +405,000 +480,000
Adjusted sales price $9,540,000 5,265,000 $8,880,000
Size in square feet 30,000 40,000 20,000 35,000
Adjusted sales price per SF $238.50 $263.25 $253.71
Average sales price per SF $251.82
Estimated value $7,554,600
The sales comparison approach is most useful when there are a number of properties similar to the subject that have been recently sold, as is usually the case with single-family homes.
When the market is weak, there tend to be fewer transactions. Even in an active market, there may be limited transactions of specialized property types, such as regional malls and
hospitals. The sales comparison approach assumes purchasers are acting rationally; the prices paid are representative of the current market. However, there are times when purchasers become overly exuberant and market bubbles occur.